Been using my 2019 Peugeot 3008 Allure for a little more than two years. I have enjoyed driving it. Aside from its award-winning safety features, I have saved a lot on speeding fines because of its speed-limiter feature. Never had that with my Yaris. *wink*

If you are driving long roads (say, Dubai to Fujairah or Abu Dhabi, and vice versa), most of the time you won’t notice that you are already above the maximum speed limit. Maybe you are so engrossed with the music you are tuning in (or audiobook for me). Then there goes your camera flash for your fine. That’s why the speed limiter saves me a lot of cash. No matter how far I push on the gas, I will never go further than the speed limit I set. But this is not a car review, this is about how much we are losing (or saving) if we want to settle the car loan early. Is it even practical to pay the car in full or is it better to have it under financing?

If you have enough cash to pay it in full, why not? At least you will not be paying on interest. Interest (plus additional loan processing charges) is supposedly your money but you just end up giving it to the bank. You could have used it to save for some of your financial goals. But for some people, they prefer loans, especially if the interest rate is low (2% – 5% per annum) and that the money which can be used supposedly to pay the car’s full price can be invested somewhere which may earn more than the car loan’s interest, say 8% or more.

For example, if they are paying a 5% interest charge on a car loan but have the money (which is supposed to pay the car in full) is invested with an 8% growth, a 3% net income is achieved, which of course an extra cash flow. That is if you have the money to pay the car in full and invest it. Otherwise, you have to go for the loan option.

I opted for car financing since it was economical for me. The disbursed amount was 92,966 AED and a monthly payment of 1,763 AED for 5 years, at 5.19% annual interest. So, in 5 years, I will have paid the bank 105,780 AED. And the interest will be equivalent to 12,814 AED – that’s a lot! If the same amount is invested in an instrument that earns 6% per year for 10 years, the 12,814 AED can become almost 23,000 AED. This 23,000 AED could have been mine if I will not pay this much interest for the car loan, and have invested it somewhere.

After 2 years of paying, last week, I decided to close my car loan. Instead of paying 1,763 AED for the remaining 36 months (a total of 63,468 AED), I settled the remaining balance of 57K AED, paid early settlement charges of 1.05% (about 600 AED). So I saved around 5,868 AED (63,468 – 57,000 – 600).

The car loan that I have is on a reducing-balance-rate. This means that the interest of 5.19% is calculated on a monthly basis as per the current outstanding loan amount. So, as the loan comes nearer to its maturity, the interest amount becomes lower because the outstanding balance becomes smaller. This explains why I only saved around 5,868 AED. Is it worth it? Let’s do the numbers for different options.

Option 1. If I continue paying the loan for 3 years, I would not be able to save anything but definitely, I will own the car which I can sell after the loan finishes.

Option 2. Paying the balance will save me 5,868 AED. Plus, I will own the car.

Option 3: Instead of paying the 57,600 AED  (including the early settlement fee of 600 AED) to close off the loan, I will invest it in an instrument with 6% annual growth for 3 years. It will provide me an income of 11,002 AED. Since the loan is still active, I will still have to pay the bank a total of 63,468 AED. By the end of the loan’s maturity, I will own the car, have an investment of 57,600 AED plus the growth of 11,002 AED. Total Asset: Car Value + 68,602 AED.

Option 4.  Pay off the car loan, and invest the allocated 1,763 AED monthly car payment to an instrument that earns 6% annually for 3 years. Upon paying the loan, I have already saved 5,868 AED and of course, the car will already be under my name. At the end of the third year, I will be able to save up 63,468 AED plus an investment growth of 7,816 AED. Total Asset: Car Value + 77,152 AED

Obviously, Option 4 is the best route if you have the lump sum to pay off the loan plus the extra cash flow to invest monthly for 3 years. Otherwise, choose whichever alternative is suitable for you. The main aim is to optimize savings and let our money work for us.

So to answer the question, is early settlement a good option? For me, it is. Because you will definitely be able to save up some extra cash which you can allow to grow somewhere else. Additionally, if you can allocate your monthly car repayment to an investment, you are also letting your money work for you.

Notes on Calculation.

1. If you would like to calculate your outstanding loan amount with a reducing-balance-rate, an excel/google spreadsheet would be helpful. Here’s an example for this car loan with 5 years to pay, for the first 10 months. [Got help from a good friend, Sherwin, who works in a bank.]

For a reducing-balance-rate, the interest is calculated monthly based on the outstanding balance. In this example, the first month’s outstanding is 92,966 AED. Applying the interest of 5.19% per year will result in 4,824.94 AED. However, banks will convert this into a daily rate, hence, 4,824.94 AED divided by 365 days is 13.22 AED per day. And since the month of November has 30 days, the interest amount for that month will be 30 days times 13.22 AED which is 396.57 AED. This interest will be taken out from your monthly instalment which will leave you with 1,366.34 AED. This will be then deducted from your beginning balance of 92,966 AED. The ending balance for the month then is 91,599.66. Do the same for the remaining months.

You will notice here that your beginning balances are not subtracted immediately with your monthly payments (e.g. 1763 AED). The banks have to take out the interest first, and only after with the remaining principal, they will subtract the outstanding balance. And that is the reason why if you add up all your 10 instalments of 1,763 AED in 10 months which is a total of 17,630 AED, this should have reduced your loan from 92,966 AED to 75,336 AED. But you will notice that your outstanding loan is still 80,494 AED on the 10th month. That is because it was not the full amount of 1,763 AED that the bank subtracted from the outstanding balance. [Download the excel template here]

2. To calculate investment growth, you can check this calculator.